1. The Design Of Fiscal Rules /1,2 Davide Lombardo International Monetary Fund Turkish Banks Association Seminar February 26, 2009 1/ The views expressed in this presentation are the authors, and not necessarily the IMFs. 2/ Based on the December 1-2 2008 workshop organized by the Treasury, SPO, and MOF together with the Fiscal Affairs Department of the IMF. In particular it borrows on the presentations by Debreu and Debreu and Kumar (available on the website of the Turkish Treasurysee press release dated 18 Dec 2008).

2. Outline First principles: (Definition, Rationale, Function) First principles: (Definition, Rationale, Function) Taxonomy Taxonomy Design trade-offs Design trade-offs Basic properties of selected rules Basic properties of selected rules Monitoring and enforcement Monitoring and enforcement Fiscal rules around the world: Fiscal rules around the world: EU sample EU sample Broader sample Broader sample Lessons from stylized facts Lessons from stylized facts Conclusions Conclusions

3. Definition Mechanism placing durable constraints on fiscal discretion through numerical limits on budgetary aggregates (expenditure, revenue, budget balance and/or public debt). Mechanism placing durable constraints on fiscal discretion through numerical limits on budgetary aggregates (expenditure, revenue, budget balance and/or public debt). Any fiscal policy rule is made of 3 parts: Any fiscal policy rule is made of 3 parts: Numerical target/ceiling on one or more specific fiscal indicators Numerical target/ceiling on one or more specific fiscal indicators Explicit cost for non-complying policymakers Explicit cost for non-complying policymakers A monitoring/enforcement procedure. A monitoring/enforcement procedure.

4. What is not a fiscal policy rule? The annual budget is not a rule, as it only applies for one year. The annual budget is not a rule, as it only applies for one year. An IMF-supported program, as it is not expected to be a permanent feature of fiscal policy. An IMF-supported program, as it is not expected to be a permanent feature of fiscal policy. The new UK rule: The new UK rule: To set policies to improve the cyclically-adjusted current budget each year, once the economy emerges from the downturn, so it reaches balance and debt is falling as a proportion of GDP once the global shocks have worked their way through the economy in full.

5. Rationale: why constraining discretion? Unconstrained fiscal policy may be perceived as systematically deviating from desirable policies. In practice: pro-cyclical and/or unsustainable policies. Unconstrained fiscal policy may be perceived as systematically deviating from desirable policies. In practice: pro-cyclical and/or unsustainable policies. Reasons why unconstrained policies can be biased: Reasons why unconstrained policies can be biased: Time-inconsistency Time-inconsistency Fiscal federalism/monetary union Fiscal federalism/monetary union Political economy: Myopia, re-election concerns, fiscal illusion, distributive conflicts, and coordination failures. Political economy: Myopia, re-election concerns, fiscal illusion, distributive conflicts, and coordination failures. Other disciplining mechanisms? Other disciplining mechanisms? Markets: yes, but unreliable (comes too late and to strongly) Markets: yes, but unreliable (comes too late and to strongly) Delegation to non-partisan technical agencies: poses considerable issues in terms of democratic accountability. Delegation to non-partisan technical agencies: poses considerable issues in terms of democratic accountability.

6. Functions of fiscal rules Rules are commitment devices: they make deviations from socially desirable targets too costly for policymakers. Rules are commitment devices: they make deviations from socially desirable targets too costly for policymakers. Rules are signaling tools: they can help policymakers signal their genuine commitment to sustainable and stabilizing policies. Rules are signaling tools: they can help policymakers signal their genuine commitment to sustainable and stabilizing policies. Rules can also serve to anchor expectations, thus reducing uncertainties and risk premia. Rules can also serve to anchor expectations, thus reducing uncertainties and risk premia.

7. Principles of a taxonomy Many parameters enter the design of an actual fiscal policy rule: Many parameters enter the design of an actual fiscal policy rule: fiscal target(s) fiscal target(s) nature of costs in case of deviation nature of costs in case of deviation monitoring/enforcement monitoring/enforcement escape clauses, etc. escape clauses, etc. A good rule must imply good policies in most (if not all) circumstances A good rule must imply good policies in most (if not all) circumstances the policy response induced by the rule to a variety of shocks is therefore key. the policy response induced by the rule to a variety of shocks is therefore key.

8. Key feature of the rules: response to shocks Limits to discretion make sense, but they should NOT: Limits to discretion make sense, but they should NOT: Prevent adequate responses (e.g., let automatic stabilizers play in bad times) Prevent adequate responses (e.g., let automatic stabilizers play in bad times) Force inadequate responses (e.g., force a fiscal contraction in response to a temporary spike in interest rate, or depreciation of the exchange rate) Force inadequate responses (e.g., force a fiscal contraction in response to a temporary spike in interest rate, or depreciation of the exchange rate) Let the bias unchecked in specific circumstances (e.g., allow for procyclical expansions). Let the bias unchecked in specific circumstances (e.g., allow for procyclical expansions).

9. The design of fiscal rules There is no one-size-fits-all fiscal policy rule. Much depends on: There is no one-size-fits-all fiscal policy rule. Much depends on: Constellation of shocks prevalent in the economy Constellation of shocks prevalent in the economy Nature and magnitude of policy bias under discretion. Nature and magnitude of policy bias under discretion. A good rule is (Kopits and Symansky, 1998): A good rule is (Kopits and Symansky, 1998): …simple …simple …transparent …transparent …coherent with the final goal …coherent with the final goal …but mindful of other goals of public policy: …but mindful of other goals of public policy: Not discouraging structural reformsNot discouraging structural reforms Allowing for fiscal stabilization (time-frame, cyclical adjustment)Allowing for fiscal stabilization (time-frame, cyclical adjustment) Avoiding low-quality adjustments (undue tax hikes, cuts in quality/priority spending).Avoiding low-quality adjustments (undue tax hikes, cuts in quality/priority spending).

10. Two key trade-offs Credibility-flexibility: allowing for greater responsiveness to shocks could undermine credibility of attaining the final goal. Credibility-flexibility: allowing for greater responsiveness to shocks could undermine credibility of attaining the final goal. Flexibility-simplicity: combinations of rules can relax somewhat the credibility-flexibility trade-off, at the cost of simplicity and transparency. Flexibility-simplicity: combinations of rules can relax somewhat the credibility-flexibility trade-off, at the cost of simplicity and transparency. The devil is in the details The devil is in the details

11. Other design issues Coverage of the government sector Coverage of the government sector Policy coordination in federal/decentralized systems Policy coordination in federal/decentralized systems Legal foundations Legal foundations Need for adequate budgetary procedures (preparation, execution, and ex-post auditing of budgets) Need for adequate budgetary procedures (preparation, execution, and ex-post auditing of budgets) Need to limit scope for creative accounting Need to limit scope for creative accounting

12. Pros and cons of selected rules Simple rules: Simple rules: Debt rules Debt rules Budget balance rules Budget balance rules Expenditure rules Expenditure rules Revenue rules Revenue rules Combined rules: e.g., debt objectives coupled with binding deficit ceilings, debt/budget balance objectives coupled with binding medium-term expenditure ceilings Combined rules: e.g., debt objectives coupled with binding deficit ceilings, debt/budget balance objectives coupled with binding medium-term expenditure ceilings

13. Balanced budget and overall deficit limits Pros: Pros: pin down asymptotic properties of debt pin down asymptotic properties of debt directly address the deficit bias directly address the deficit bias can be simple and transparent (unless cyclical considerations, escape clauses, etc). can be simple and transparent (unless cyclical considerations, escape clauses, etc). Cons: Cons: procyclical (unless cyclically adjusted or over the cycle) procyclical (unless cyclically adjusted or over the cycle) could force cut in investment… could force cut in investment… golden rule, but these open door to manipulations, and do not guarantee debt sustainability. golden rule, but these open door to manipulations, and do not guarantee debt sustainability. Overall vs. primary balance? Overall vs. primary balance? Primary is more robust to volatility in interest payments. Deficit Rules

14. Upper limit (or desirable time path) for gross or net public debt Pros: Pros: Directly tackle debt sustainability Directly tackle debt sustainability Can be transparent and simple Can be transparent and simple Can accommodate large shocks if debt is well below the ceiling Can accommodate large shocks if debt is well below the ceiling Cons: Cons: Lack controllability Lack controllability Can force procyclical and undesirable responses to interest rate and exchange rate shocks if debt is close to the limit Can force procyclical and undesirable responses to interest rate and exchange rate shocks if debt is close to the limit Borrowing constraints generally applied at regional and local levels Borrowing constraints generally applied at regional and local levels Debt Rules

15. Expenditure Rules Set expenditure ceilings (nominal or in terms of GDP) or limits on growth (nominal or real). Pros: Pros: tackle one of main source of deficit bias tackle one of main source of deficit bias translate directly into budget preparation translate directly into budget preparation minimizes pro-cyclicality risks minimizes pro-cyclicality risks fosters medium-term planning fosters medium-term planning Cons: Cons: May leave room for discretionary tax cuts sustainability? May leave room for discretionary tax cuts sustainability? complex to design (nominal vs. real, exclusions,…) complex to design (nominal vs. real, exclusions,…) Best used in combination with deficit or debt rules. Best used in combination with deficit or debt rules.

16. [Revenue Rules] Rules imposing limits on revenues with a view to: Rules imposing limits on revenues with a view to: Contain size of the public sector / tax burden Contain size of the public sector / tax burden Allocate ex-ante revenue windfalls (e.g., due to surprisingly high growth) Allocate ex-ante revenue windfalls (e.g., due to surprisingly high growth) Pros: Pros: Can reduce procyclicality in good times Can reduce procyclicality in good times Cons: Cons: Limited impact on deficit bias if not coupled with other rules Limited impact on deficit bias if not coupled with other rules Can be procyclical in case the rule targets a given revenue-to- GDP ratio (due to the progresssivity of the tax system) Can be procyclical in case the rule targets a given revenue-to- GDP ratio (due to the progresssivity of the tax system)

17. Combination of rules Drawbacks with individual rules have led most countries to adopt combination of rules Drawbacks with individual rules have led most countries to adopt combination of rules Most common combinations: Most common combinations: Debt and overall deficit ceiling and overall balance target (e.g., Maastricht) Debt and overall deficit ceiling and overall balance target (e.g., Maastricht) Overall balance and expenditure ceilings (Sweden, Finland, Netherlands, etc). Overall balance and expenditure ceilings (Sweden, Finland, Netherlands, etc).

18. Monitoring Ex-ante auditing: Ex-ante auditing: Is the government proposed fiscal policy consistent with the rule and its objectives? Is the government proposed fiscal policy consistent with the rule and its objectives? Ex-post assessment: Ex-post assessment: Was the rule implemented? Was the rule implemented? Analysis of underlying policiesAnalysis of underlying policies Certification role: track attempts to resort to creative accountingCertification role: track attempts to resort to creative accounting Assessment of ex-post adjustments to the target (CABs,…), activation of escape clauses, etc.Assessment of ex-post adjustments to the target (CABs,…), activation of escape clauses, etc.

19. A key pre-requisite Budgetary transparency: Fiscal data need to be accessible, timely, and reliable Fiscal data need to be accessible, timely, and reliable Comprehensive periodic reporting requirements Comprehensive periodic reporting requirements Clarity about the budget preparation and execution procedures Clarity about the budget preparation and execution procedures Clarity about roles and responsibilities of different levels of government Clarity about roles and responsibilities of different levels of government

20. Fiscal councils Independent institutions with Independent institutions with country-specific mandates country-specific mandates adequate and highly qualified staff adequate and highly qualified staff guaranteed multi-year budget. guaranteed multi-year budget. Can contribute to greater transparency and accountability of fiscal policy. Can contribute to greater transparency and accountability of fiscal policy. Can help monitoring and enforcing a rule. Can help monitoring and enforcing a rule.

21. The case of Chile Fiscal institutional setup designed to buttress fiscal sustainability and dampen cyclical fluctuations. Fiscal institutional setup designed to buttress fiscal sustainability and dampen cyclical fluctuations. Rule: maintain a structural surplus of 1 percent of GDP for the central government. Fiscal expenditures follow the dynamics of structural revenue. Rule: maintain a structural surplus of 1 percent of GDP for the central government. Fiscal expenditures follow the dynamics of structural revenue. Two independent expert panels provide key projections: Two independent expert panels provide key projections: 1. the inputs (growth of the labor force, real investment, and total labor productivity) for estimating trend GDP 2. ten-year forecasts of the price of copper. Independent panels enhance policy credibility, while allowing some policy flexibility. Independent panels enhance policy credibility, while allowing some policy flexibility.

22. The case of the Netherlands The Central Planning Bureau plays a key role in the budgetary process: The Central Planning Bureau plays a key role in the budgetary process: Provides projections and forecasts Provides projections and forecasts Estimates desired structural budget balance Estimates desired structural budget balance Vets the programs of all political parties (which are thus subject to reputational sanctions) Vets the programs of all political parties (which are thus subject to reputational sanctions) Undertakes analysis of specific budgetary projects. Undertakes analysis of specific budgetary projects. High credibility borne out of tradition High credibility borne out of tradition

23. Fiscal Rules: International Experience Stylized facts for EU (EC database: annual data over 1990-2005), and the rest of the world (IMF-FAD database on the design and implementation of fiscal rules) Stylized facts for EU (EC database: annual data over 1990-2005), and the rest of the world (IMF-FAD database on the design and implementation of fiscal rules) Worldwide: 81 countries identified as having fiscal policy rules, with complete information for 77 of them Worldwide: 81 countries identified as having fiscal policy rules, with complete information for 77 of them

24. Growing appetite for fiscal rules (EU)

25. Emerging Market and LICs are catching up with industrial countries

26. Budget-balance and debt rules dominate, but expenditure rules are increasingly popular

27. Expenditure and revenue rules are thus relative newcomers

28. Same trends in EU sample

29. Budget balance rules appear stronger and have wider coverage

30. This is reflected in synthetic measures of strength and coverage

31. Strength and coverage relatively similar across countries

32. Features by country groups

33. Fiscal rules lower interest rates (EU-25) Debrun and Joshi (2008)

34. All key dimensions matter deliver lower interest rates. All key dimensions matter Effective rules deliver lower interest rates. Debrun and Joshi (2008) Fiscal rules lower interest rates (EU-25)

35. Lessons Historical preference for deficit and debt rule Historical preference for deficit and debt rule But recently emergence of expenditure rules (in combination with BBRs and DRs) But recently emergence of expenditure rules (in combination with BBRs and DRs) What explains the trends for more rules and more expenditure rules? What explains the trends for more rules and more expenditure rules? Increasing realization that purely discretionary fiscal policies are inconsistent with sustainability (growing public debt) Increasing realization that purely discretionary fiscal policies are inconsistent with sustainability (growing public debt) Mounting pressures from long-term issues: aging, global warming, etc. Mounting pressures from long-term issues: aging, global warming, etc. Regional monetary unions. Regional monetary unions.

36. Conclusions Well-designed fiscal rules can help improve fiscal performance on average… Well-designed fiscal rules can help improve fiscal performance on average… …thus lowering risk-premia and interest rates on long-term government bonds. …thus lowering risk-premia and interest rates on long-term government bonds. But: political commitment is key But: political commitment is key As are adequate public financial management, monitoring and enforcing systems. As are adequate public financial management, monitoring and enforcing systems.